Brazil’s Manufacturing Growth Puzzle

For years, protectionist policies helped Brazil build a fortress around its manufacturing base, which profited from a rapidly expanding domestic market over the past decade. Automakers, home appliance manufacturers, and their supplying industries have seen their output rise as consumers went on a shopping spree motivated by a surge in employment and inflation-adjusted incomes. Ever-rising purchasing power and the best credit conditions in decades fueled the demand for durable goods and housing, in turn stimulating most intermediate industries. A sort of virtuous cycle led to a broad-based manufacturing expansion that was interrupted in the wake of the 2008 global economic crisis. It took Brazilian factories more than a year to recover pre-crisis output levels, and manufacturing subsequently stopped growing (Figure 1). Three years have passed without genuine manufacturing growth in Brazil, despite the government’s protectionist stance that is ingrained in every sector of the economy.

Manufacturing activity has generally mimicked the path of the overall economy in Brazil, an expected outcome in a protected environment. Figure 1 shows the high correlation between Brazil’s GDP proxy and manufacturing production index between 2003 and 2008. The 2008 crisis seemingly created a structural break, leading these two variables on divergent paths once activity reached pre-crisis levels in early 2010. While manufacturing production stopped growing in March 2010, Brazil’s economy kept expanding, although at a more moderate rate. Surprisingly, this growing disconnect between manufacturing and GDP has been taking place in the midst of a surge in protectionist policies.

Many observers ask how Brazil’s economy can grow without the expansion of manufacturing. The answer is fairly straightforward: China’s strong demand for iron ore and agricultural commodities—notably soybeans—explains most of the country’s GDP improvement. Growth in the mining and agricultural sectors and associated services helped Brazil’s economy keep afloat in the last three years.

Most important to MAPI member companies is why manufacturing has been so sluggish in this time frame. From a macro point of view, sustained currency strength and low overall productivity have hurt the competitiveness of local factories, making Brazil’s manufactured goods relatively more expensive than imports. Currency strength explains part of the problem, since substituting locally made goods for relatively cheaper imports is limited by protectionism. So, if imports are deterred, why is it that local manufacturers are not expanding output to keep up with rising demand? A careful examination of most credible surveys among Brazil’s captains of industry suggests that a lack of qualified labor is at the heart of the manufacturing slump, which in turn helps explain why GDP growth is concentrated in capital-intensive sectors such as agriculture and mining.

Skilled labor is in short supply and is one of the most significant growth barriers for Brazil’s labor-intensive manufacturing industry. Industrial surveys undertaken by the most prestigious research institutions in Brazil over the last few years ranked the lack of qualified labor as one of the most critical barriers to manufacturing growth, along with the high tax burden. With the current tax reductions benefiting a broad range of manufacturing industries, the National Confederation of Industry’s latest surveys have shown a decline in the percent of respondents listing the tax burden as one of the major problems facing factories. On the other hand, the proportion of respondents calling out the lack of qualified labor continues to rise. The organization’s quarterly Manufacturing Costs report reveals that the cost of labor is rising at least twice as fast as the overall cost of manufacturing index, and is—by far—the index’s fastest-growing subcomponent. While the overall cost of manufacturing index grew 6.1 percent in 2011 and 6.6 percent in 2012, the cost of labor surged 10.5 percent and 11.2 percent, respectively.[1]

Historically and currently, the well-known Custo Brasil—“the cost of doing business in Brazil”—was the main culprit of the lack of sustained economic growth. Firms must contend with one of the highest tax burdens in the world, poor infrastructure, prohibitive credit conditions, expensive energy, and a lack of qualified labor. The government has recently focused on driving competitiveness in the economy by lowering taxes and energy costs. It has engaged in a series of concession schemes for private sector companies to develop roads, railways, and airports.[2] Infrastructure takes time to be developed, however, so the benefits will take time to be realized. Except for some increased budget allocations for education that may pay off years from now, nothing can be done in the short- and medium-term to generate the quantity and quality of labor desperately needed for growth and lower inequality readings.

Amid the industrial complex’s standstill and the government’s initiatives to foster local manufacturing—protectionist policies, tax reductions, lower energy costs, etc.—tensions are rising between public officials and the country’s captains of industry. The most powerful trade association in Brazil, the Federation of Industries of the State of São Paulo (FIESP), is facing increased government pressure to ensure a pickup in production levels and employment. The government believes that it is making overly generous efforts to protect and stimulate local manufacturing without an appropriate response from industry. Some officials are inclined to open up sectors to retaliate against what they see as an indolent local industrial bourgeoisie. While a growing number of authorities in Brazil think that competition could help “wake up” a dormant local industry, the majority of high-ranked officials are afraid of the employment consequences of trade liberalization, and prefer not to open the fortress.

The truth is that there are structural barriers to expand Brazil’s manufacturing industry in the short- and medium-term. A lack of qualified labor and poor infrastructure will keep production costs elevated for some time, since there is no easy fix. Currency strength does not help, either, but currency devaluation is not a solution—the competitive gains of a weaker real would be quickly offset by rising inflation because of higher costs of imported intermediate goods. It seems that absent a major influx of qualified workers—unlikely in an inward-looking society—growth can be achieved only through the opening of the economy; the prevailing ideology in Brasilia goes against that, however. Our upcoming forecasts for Brazil suggest that an ongoing favorable cycle (partly explained by public and private investments related to the 2014 World Cup and 2016 Olympic Games) will foster manufacturing production in the next few quarters. Tensions will thus decline, but the underlying problems will likely continue to limit the growth of the local industrial complex and open the door for eventual policy shifts.